Institutional Funding/Venture Capital – Due Diligence – Tom Walker, Rev1 Ventures President and CEO
Note: “Rules for Startups Raising Capital in the Midwest” is a multi-part Entrepreneur Toolkit series based on Rev1 Ventures Capital Access Learning Lab. We suggest you review all sections: Part 1 – Basic Information on Venture Capital, Part 2 – Capital Planning Worksheet, Part 3 – Building Your Investor List, Part 4 – Due Diligence, Part 5 – Investor Outreach, and Part 6 – Deal Terms.
This material is also available in Rev1’s Toolkit eBook – Rules for Startups Raising Capital in the Midwest (download here.)
Investing in startups is inherently risky business. Due diligence is the rigorous process venture capitalists and other investors use to identify and assess every deal’s specific risks.
Ultimately, the validations, discoveries, and, yes, surprises produced in due diligence determine whether a venture capitalist fund or investor invests in the company. Successful entrepreneurs understand that preparing for due diligence is preparing for success.
What Is Due Diligence?
Due diligence is a process by which investors verify and analyze the inner workings of a business. Their goal is to gain the best understanding possible of the business to aid in their investment decisions.
Formal due diligence often (but not always) includes a checklist of items that investors want to see and a set of questions or requests to aid in their analysis. Here is a comprehensive example from the Angel Capital Association.
However, due diligence begins well before the checklist arrives. Due diligence begins the moment a qualified investor asks the first question about your business plan. Especially in the early days of discussions and relationship building with a potential investor, due diligence can be anecdotal, information, and conversational.
The more serious an investor becomes, the more formal, documented, and detailed the due diligence requirements will be. Due diligence investigations become increasingly deeper until the investor(s) purchases equity in your company or decides to walk away from the deal.
Often, but not always, they supply a set of questions that drive their process in their investigation. You can expect requests for information covering every aspect of your business, including background checks on you and your management team.
- Financial and business models
- Human Resources
- Legal and corporate matters
- Primary research and intellectual property sources and protections
- Product development
- Sales and marketing
- Strategic Planning
Create a Data Room
Develop due diligence discipline from the beginning company. Do not wait until an investor is interested and starts asking for more information. Due diligence shouldn’t be a scramble but a mindset.
Create an online, virtual data room that provides scalable storage capacity and allows for data sharing. There are many secure, cloud-based tools available for storing and accessing company-sensitive and confidential data, from Box to Google Drive, to Vault Rooms, and more. Consider ease of use, accessibility, and cost. Take the appropriate steps to safeguard the privacy and data security.
Pre-populate the data room as you build the company. You can start with your articles of incorporation and the current resumes and references for each startup team member. Every time the company signs a contract or a financial agreement—from leasing space to equipment purchases, store the documents electronically in the data room—the same for every item relating to human resources, from interview rubrics to non-disclosure agreements.
Document your investor pitch in the data room. That includes your customer pipeline, financials, strategic partnership agreements, development contracts, patent filings, and more. Individual investors will have unique requests, but you can pre-populate your data room.
- Breakdown of capital needs
- Cap table
- Employment contracts
- Examples of major contracts
- Financial model
- Formation documents
- Intellectual property
- Market/competitor analysis
- Patents, patent applications
- Pitch deck
Institutional Investors Expect You to Be Prepared
It takes time to build out a capital access plan and to prepare for due diligence. Then due diligence to closing can easily take six months once your startup becomes an active investment prospect. Don’t slow the process down by being poorly prepared.